2018-02-06

An extremely popular trade over the last few years has been the "short volatility" trade. As the S&P 500 has gone virtually straight up over the last few years, with no serious corrections or volatile periods, increasingly large bets have been placed on the continuation of a bull rally with low volatility. Investors have learned that buying the dips and always betting on a drop in volatility is very profitable.

This trade is epitomized by the two exotic ETFs XIV and SVXY with $4 billion of assets. SVXY is short VIX futures, and XIV makes essentially the same bet though it holds no assets. It is an unsecured debt note from Credit Suisse, strictly speaking an ETN (exchange traded note).

Both ETFs have shown spectacular performance over the last 5 years, about 40% annual return. Because betting on the continuation of low volatility has been so profitable, money has flooded into these trades. In addition to the $4 billion in these two funds alone, many other institutions and hedge funds make similar bets, probably adding another few billion $ in similar positions.

The exact nature of these ETF bets is hard to explain. It's not exactly a bet on low volatility, but rather that volatility will turn out to be lower than currently expected. It doesn't really matter. The ETFs are exotic derivatives, detached from reality.

Monday, February 5, 2018

A spike in volatility on the heels of a couple bad days in the stock market caused a sharp sell-off in XIV and SVXY. The futures-based SVXY instrument fell 32% in regular trading, though XIV (suspiciously) only fell 14% initially. After hours, both instruments crashed 90% or more. Just for fun, I bought some XIV at $11. It had opened Monday at $115.

There is a good chance that one or both of these funds could become worthless tomorrow.

These ETFs could make VIX spike

You might be tempted to dismiss these ETFs as a side-show and just another stupid investment, but I think there is something more significant happening. There is now a serious risk of a VIX derivative blowup, or it might have already started on Monday.

If volatility stays elevated, these funds will see tremendous losses since they are short VIX futures (or in the case of XIV, Credit Suisse is short futures behind the scenes to balance their fund exposure).

As the funds disintegrate, something interesting happens. In liquidating and collapsing, the funds are forced to aggressively buy VIX futures as they cover their short exposure. SVXY for example was short around 125,000 VIX futures contracts worth around $2 billion as of February 2.

Just how big is that exposure? SVXY is short 18% of all February VIX contracts and 39% of all March VIX contracts. This data may be a bit stale but you get an idea of how significant this one fund's holdings are. Now take into consideration that XIV has similar exposure, and you can see that either XIV or SVXY (and heaven forbid, both) funds will absolutely move the futures market if they are forced to buy.

If one or both of these funds unwinds or dissolves tomorrow, here is what might happen:

The fund(s) are forced to buy front month VIX futures as they liquidate

The price of the contract spikes, like in any short squeeze

Other institutions currently short the futures are also forced to buy

Traders and algorithms watching the VIX futures absolutely freak out

Everyone becomes risk-averse, dumps stocks, liquidates, etc.

Causing the VIX to go even higher

In this way, the blowup of the "short volatility" ETFs could spark a cascading situation and cause significant volatility to occur. This is a very unpredictable situation.

Let's be optimistic

On the other hand, volatility might subside Tuesday, in which case this would not play out. Another possibility is that this scenario already played out on Monday, and maybe the insane spike in VIX (from 17.5 to 37.5) occurred precisely due to this. Perhaps we are entering Tuesday with the short contracts already covered, and no further fuel on the short squeeze.